Chinese Stocks Face a Gaping Credibility Gap

New Oriental episode highlights risks, opportunities in the sector

For someone who closely follows China and the stocks tied to her fortunes, the recent turmoil in New Oriental Education (NYSE:EDU) is a painful reminder that things can go terribly wrong, terribly fast.

On July 17, shares of China’s leading private education provider plunged more than 34% after the company announced it was under investigation from the Securities and Exchange Commission over the consolidation of its units’ financial statements. The stock lost another 35% the following day, and that was despite reporting Q2 earnings that handily beat consensus expectations.

Many other Chinese bellwethers suffered collateral damage from the New Oriental blow up, including Ctrip.com (NASDAQ:CTRP), Changyou.com (NASDAQ:CYOU), NetEase (NASDAQ:NTES), Youku (NYSE:YOKU) and Renren (NYSE:RENN). The sector’s selloff highlights the lack of credibility that Chinese stocks have with investors, and the collapse of New Oriental Education illustrates how difficult it is to invest in Chinese companies these days.

Now, unlike the many obscure Chinese companies that blew up in 2010 and 2011, New Oriental is a household name in China, with millions of past and present customers throughout the country. The company’s founder, Michael Yu, and several of his early employees are virtual celebrities in China.

Because New Oriental is an immensely successful business with a great reputation, it is unlikely that someone like Yu would commit large-scale fraud to cheat investors. Yet shareholders understandably ignored these deeper issues and dumped the stock in panic selling, automatically assuming that if it’s a Chinese company, it might indeed be guilty of fraud.

Click to Enlarge To make matters worse, the usual cast of bad actors — i.e., professional short-sellers, ambulance chasers and rumor-mongers — ganged up on the stock after news of the SEC broke. And though EDU shares spiked higher after the company formed an independent committee to review allegations raised by short seller Muddy Waters LLC about the company’s accounting practices, most of the damage to the shares had already been done.

The New Oriental episode reveals the deep lack of trust on the part of investors regarding Chinese companies, and to me, that’s very unfortunate. This credibility problem has made Chinese stocks less relevant as sound investment vehicles, even as China has became far more relevant as an economic power.

Today, investing in Chinese stocks has become akin to trying to find gold in the midst of a minefield. It is for this reason that I’ve decided to invest in China via global companies that benefit from China’s economic growth, instead of companies based in China.

Make no mistake, China’s emergence as a global powerhouse is very real despite the recent slowdown in the rate of GDP growth. In a sluggish economic world, it is important for growth investors to invest in companies — whatever the country of their origin — that are benefiting from the Asian giant’s economic rise.

That’s why some of my favorite China plays include global consumer powerhouses like Apple (NASDAQ:AAPL), Coach (NYSE:COH), Louis Vuitton Moet Hennessy (MUTF:LVMUY) and Starbucks (NASDAQ:SBUX). Each of these companies does exceedingly well in China, and much of their future growth will come from well-heeled Chinese consumers.

During the past two years, Chinese stocks have underperformed U.S. stocks despite continued economic growth in the country that far exceeds the growth rate in the United States. During this same period, I have diversified away from pure Chinese stocks into other growth stocks that benefit from China.

If you want to profit from China’s still-powerful economic presence, start thinking about ways to invest in China’s growth without taking on the credibility risk.

Robert Hsu is the Editor of the China Strategy and Asia Edge advisory services. He currently recommends EDU, CTRP, CYOU, NTES, AAPL, COH, LVMUY and SBUX.